How do insurance companies make money?

What if I’ve only paid one premium and then write off my R140,000 vehicle in an accident the next day?

I’ve often asked myself that very same question…
Or how about this question: “How would you start a brand new insurance company from scratch?”

I mean think of it…

You’ve placed your first ten clients on books, and

In the process collected R10,000 in premiums.

Next day your first client phones in and says he’s written off his R140,000 car

R10, 000 in payments collected versus R140,000 to be paid out!

I don’t know about your business, but in our businesses it means closing the doors (…and a lot of ducking and diving)!

But before we get to the theoretical version of how insurers make money, let’s go back a few thousand years, to the very beginning of the insurance industry…

How they insured in the good ole days!

The story goes that Chinese merchants made use of rivers to transport their goods from place to place. Now instead of putting all their worldly possessions on just one boat they would spread their wares between a couple of boats – that way, if one of them capsized, then they wouldn’t lose everything.

Move forward a couple of thousand years, and we have a similar scenario which also involved boats…albeit one boat only!

This is how it worked…
All the merchants who were shipping goods together on this one boat paid a premium in proportion to the value of the goods they were shipping. If the ship encountered a storm and any goods had to be jettisoned, then the merchant who suffered the loss was reimbursed via this premium.

So how do they do it today?

Insurers make money in two ways:

From underwriting your risk and then charging an appropriate premium for the risk they face.

Then investing your premiums into the stock market and hopefully making a profit!

This is how it works today…
Insurers have access to tons of data which allows them to predict the likelihood of a claim. Once they know the likelihood of a claim happening, their actuaries then determine the appropriate premium to charge for accepting this risk. If they feel the risk is too high, they may even decline the risk!

Once the insurer receives your premium they immediately invest the money.Profit is made up of premiums collected on a policy, plus investment growth made on that policy less amounts paid out in claims less underwriting expenses.

The secret lies in underwriting enough ‘winning’ policies in order to pay out the claims from all the ‘losing’ policies!

Obviously it isn’t always possible to have more ‘winning’ premiums than ‘losing’ premiums…and it’s in times like these that the investment account comes in handy as it helps balance the books.

But what happens when the investment market is down?

Quite simple really…premiums go up in order to balance the claims. Underwriting decisions also become a lot stricter!

This brings us to the one cost that seriously threatens the affordability of insurance premiums

“Why do my motor vehicle premiums go up each year while the value of my car is dropping every year?”

Makes sense doesn’t it…”my car has halved in value over the past five years, so why haven’t my insurance premiums done the same?”

A while back Momentum short term insurance claimed that total vehicle losses account for only 27% of their total claims experience.
The remaining 73% of their claims are linked to the cost of spare parts (15% + increase), panel beating labour (increased of more than 30% in 2008), towing (100% increase), windscreen prices (14% increase), salaries, etc.

So what they’re saying is that, while the value of your vehicle has dropped, the cost of actual repair has gone up!

Interestingly, Momentum calculates your premium as follows:

The premium for the 27% of claims caused by total loss is reduced by the percentage that your vehicle has depreciated for the year.

The premium for the 73% of claims caused by partial loss is increased by the average inflation in their costs for the year.

Makes sense doesn’t it…the price of spare parts isn’t going down from year to year…panel beaters aren’t working for less this year than last year, so why expect that your insurance premiums will come down?

In fact, insurers who reduce your premiums in line with the reduced value of your vehicle are more likely to increase your premiums ad hoc later in the year!

The bottom line…
As the costs of claims rise, insurers have only two routes open to them in order to remain liquid:

Raise their premiums and/or become much stricter on accepting/declining risk, or

Generate greater returns from their investments

So how does this impact you and me?

There are two types of persons who insure:

The person who faithfully pays his premiums and who only claims when necessary

The person who believes that he must ‘use’ or ‘lose’ his insurance premiums.

The first individual deserves lower premiums and earns them via a ‘no claims bonus’ which is earned for each and every year he doesn’t claim (Remember – it’s a ‘no claim bonus‘ and not a ‘no blame bonus‘!).

The second individual loses his ‘bonus’ every time he claims (and gets a hefty increase as well). Not only this, but if he becomes a moral hazard, the insurance company can, and will, ask him to place his insurance business elsewhere (Unlike life insurance, where once they’ve accepted your risk they’re stuck with you!).

Usually you’ll find that when the insured’s premiums become too expensive, he or she starts shopping around for a cheaper insurer, which is why insurers want to know your previous insurance history!

The problem arises when the amount spent on claims cannot be recouped via penalising those who claim a lot. In order for the insurer to survive and make a profit, costs must rise across the board!

In the next post regarding short term insurance we’ll discuss what exactly your short term policy promises to do as well as the roles and rights of the insurer and the insured.